Journal of Tax Credit Investing

Will tax equity fund ratings make a difference?

by William J. Guthlein, Principal, WJG Associates

Moody's Investors Services stated in December that it will rate both guaranteed and unguaranteed low-income housing tax credit (LIHTC) equity funds. To date, Moody's has publicly rated three guaranteed funds. Of these, one - based on an analysis of its underlying strength - received a rating above that of the guarantor.

The Moody's article indicates that an analysis of the syndicator's profile and the fund's properties could result in ratings in the Baa or A range for underlying strength. Higher ratings would be available to more highly rated guarantors. The general rating criteria are familiar to industry participants. For the properties, Moody's intends to emphasize debt coverage, occupancy, market advantage, physical condition, and mitigation of construction and lease-up risk.

The rating of LIHTC equity funds is an extension of Moody's more than 30 years of rating housing debt. In 2002, the agency rated in excess of $12 billion of municipal housing bonds including multifamily, single-family, public housing, military housing and student housing transactions. The company has also assigned issuer ratings to 34 state housing finance agencies, which are often tax credit allocating agencies.

Moody's expects fund ratings to provide value and efficiencies to current industry participants as well as potential new investors. The company pointed out that in other markets, its independent assessment of risk has improved both transparency and liquidity and has reduced the transaction costs. Moody's officials are confident that its analysis of the underlying assets and the syndicator's management abilities will identify the higher quality funds.

Moody's also analyzes the legal documents supporting the funds. While guaranteed funds have typically been priced off the guarantor's rating, Moody's has found that guarantee agreements provide differing levels of protection. Rating guaranteed funds provides investors with additional analysis and protection.

Industry participants expressed a wide range of opinion about whether and how the availability of investment-grade rated investments will affect the market. Al Vaccaro, managing director of Bank of America's Leasing and Capital Group, contends that ratings could change industry dynamics by enticing new investors into the market, improving fund liquidity and transparency, defining high quality underwriting, and streamlining the due diligence process.

"There are investment-grade buyers who don't have real estate expertise and won't dig deep. Over the long run, investment-grade ratings will attract new investors," he said. "It should have a positive impact on yields from the syndicator's perspective."

According to fund syndicator Boston Capital, funds that are rated as investment grade will attract new investors. However, it adds, the role of rated funds in the unguaranteed market would tend to be limited as a consequence of both investor preference and industry structure.

"We see the rating as having less value to current unguaranteed investors," said Jeff Goldstein, Boston Capital's COO. "The unguaranteed buyer has made a decision that it wants as much yield as possible. I'm not convinced buyers will give up yield for a rating."

Kevin Costello, executive vice president and director of institutional investing at Boston Capital, noted that an investment-grade rating is unlikely for a fund with pre-stabilized properties in construction and lease-up.

Warehousing properties conflicts with the syndicator's desire for deal velocity in order to maximize use of limited credit lines. Costello therefore is dubious that many stabilized funds will be available to rate.

However, ratings will be a more important factor for guaranteed funds where yields are clearly credit sensitive, predicted Steve Smith, The Richman Group's executive vice president. "A rating could help lower the yield, and I think would make more of a difference."

Still, many investors indicate that a rating would have only a marginal value to them. Some challenged Moody's underwriting expertise in the area despite its history of rating affordable housing bonds and other real estate projects.

"We do our own due diligence and never rely on outside parties," one large investor noted. "A rating wouldn't change our investment behavior and we wouldn't pay for it."

Moody's could highlight "the big difference between the best quality syndicators and their product and others," commented David Kunhardt, vice president of tax credit investments for Aegon USA Realty Advisors, Inc. He added that although ratings could smooth the investment approval process, he is nonetheless generally unenthusiastic about the value added. An investment-grade rating would not address one of Kunhardt's key objectives - reducing the high capital charge assessed by the National Association of Insurance Commissioners, a charge that is typically mandated by the partnership structure and is not credit sensitive.

High pre-tax yields

"Ratings are more interesting on the unguaranteed side," said Union Bank of California Senior Vice President Jim Francis. "The perception of unguaranteed funds is that they are riskier than an investment-grade tranche of a MBS [mortgage-backed security]. An 11% to 12% pre-tax equivalent yield from a fund with an A rating is a big difference from an equivalent bond. Ten-year A-rated corporate bonds traded at yields of roughly 5.5% in December.

"From a credit perspective, the tax credit equity funds compare favorably to many of the other real estate asset classes. If the ratings can provide some objective measure of risk, then we believe they provide an important service in this market," said Susanne Forsyth, vice president and senior analyst at Moody's Investors Service.

In November, Moody's rated a $30 million fund sponsored and guaranteed by Lend Lease as A1, an upper-medium investment-grade rating. That rating is four levels higher than Lend Lease's own lower investment-grade corporate rating of Baa2. In announcing the rating, Moody's noted that the rating was "based upon the underlying affordable multifamily pool and strength of the fund structure, as well as the strong management and oversight provided by the fund syndicator."

The Lend Lease guaranteed fund consisted of eight properties in five states with hard-debt levels of 0% to 65%, debt-service coverage between 1.19x and 1.46x, and occupancy rates of 90% or above. The yield to the investor was reportedly 5.65%.

Martha Shults, a principal in Lend Lease's housing and community investing group, worked on the rated guaranteed fund. "I see an immediate benefit in the guarantee market," she said. "Ratings open up the product to investors who are less sophisticated about real estate and the tax credit. We are intrigued by the possibility to broaden the market and achieve better pricing. Achieving a rating raises the bar. It provides a distinction [compared to other sponsors]."

In December, Moody's gave an A1 rating to a $33 million fund guaranteed by Union Bank of California (UBC). Moody's based this rating on the creditworthiness of the bank, which is also rated A1, and on a review of the fund's legal documents. The fund consisted of properties directly held by UBC and was ultimately sold to an insurance company investor. The bank had sought a rating to facilitate the fund's closing.

"Although there was no yield differential [due to the rating]," said UBC's Francis, "the deal just wouldn't have gotten done without the rating. You could say the rating helped to broaden the market."

Lend Lease's Shults also indicated that while the rating on its fund did not directly affect yield, it did assist the closing process.
Moody's first publicly rated a fund in March 2002, when it assigned a Aaa rating to SunAmerica Affordable Housing Partners 72, the same rating as that of the guarantor, AIG. The fund was originally acquired in June 1998 and is still held by Union Bank.

William J. Guthlein, CFA, CPA, recently formed WJG Associates, a consulting firm serving the needs of affordable housing investors and guarantors.

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